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1 FISCAL SUSTAINABILITY IN THE PRESENCE OF SYSTEMIC BANKS: THE CASE OF EU COUNTRIES Agnès Bénassy-Quéré and Guillaume Roussellet NON-TECHNICAL SUMMARY In the wake of the global crisis, advanced economies suffered dramatic deteriorations of their fiscal balances, due to bank bail outs, fiscal stimulus packages and the action of automatic stabilizers. In the Euro area, this deterioration triggered a severe sovereign debt crisis. Still, prior to the crisis, a number of European countries such as Ireland and Spain had been praised for fiscal discipline. Such brutal change of status from best to worst in class has questioned traditional analyses of fiscal sustainability. The Stability and Growth Pact has been revamped to account for excess leverage in the private sector and cumulated losses in competitiveness. Furthermore, in times of a financial crisis, the government may be obliged to bail out the so-called Systemically Important Financial Institutions (SIFIs), whose failure would put the whole financing system at risk. To our knowledge, there has been little attempt to include these off-balancesheet liabilities into a consistent analysis of fiscal sustainability. One exception is European Commission (2011) that, based on a model of bank default combined with data from Bankscope and a standard statistical model of credit risk, simulates the probability that fiscal sustainability is put at risk. The task is however extremely difficult given the lack of clarity surrounding the definition of SIFIs, and the fragility of any evaluation of the fiscal cost in case of a bail out. Last but not least, the probability of a systemic banking crisis is difficult to evaluate. This paper provides a first attempt to incorporate off-balance sheet, implicit insurance to SIFIs into a consistent assessment of fiscal sustainability, for 27 member states of the European Union. To do so, we first calculate tax gaps à la Blanchard (1990) and Blanchard et al. (1990). We then introduce two alternative measures of implicit off-balance sheet liabilities related to the risk of a systemic bank crisis. The first one relies on microeconomic data at the bank level collected and released by the European Banking Authority in the occasion of its second wave of stress tests (July 2011), or alternatively on a measure of banks capital shortage in the event of the financial crisis, as provided by the Volatility Laboratory of New York University. The second approach relies on macro-econometric estimations of the probability and the cost of a systemic banking crisis, based on historical data gathered by and Laeven & Valencia (2008, 2010) and Reinhart & Rogoff (2010). The former approach tends to maximize the fiscal cost of systemic banking crises since it assumes that in the event of a crisis, all SIFIs would need to be bailed out by the government. In turn, the latter approach tends to minimize the fiscal cost as it relies on historical data involving countries where generally the banking sector represented a limited share of the economy. Hence we believe that the combined use of these two methodologies helps to gauge the 3

2 range of fiscal risk. Depending on the measure of the costs (either micro or macro) and on the data source, we find contrasted impact of the banking risk on the tax gap of the different countries under review, ranging from a few tenths of percentage points (macro-based approach for "old" member states) to several percentage points (micro-based, EBA approach). In between, the micro-based (V-Lab) approach suggests that systemic banking risk could raise tax gaps by around one percentage point. In fact, the probability of a systemic banking crisis is found limited but the fiscal cost in case of a crisis can be very high. This suggests to complement our expected-cost analysis with a value-at-risk analysis. However, it is already difficult to estimate the probability of a systemic banking crisis based on a limited number of events. Recovering the whole distribution of costs in order to perform a value-at-risk analysis cannot be envisaged. The solution then would be to perform stress tests, e.g. to calculate the impact of the worst-case scenario on the tax gap, with a unitary probability. However, given the amounts involved (even in the macro-based case), tax gaps would no longer provide any information on fiscal sustainability. Rather, this approach would point to the needs to avoid any implicit government insurance granted to the SIFIs, except maybe after the building up of a dedicated fund financed through the SIFIs themselves and/or restricting such insurance to part of banking activities: SIFIs are not only "too big to fail"; they are "too big to save". More generally, our work illustrates the limits of stress testing. In the case of a very detrimental scenario, fiscal sustainability can be at risk whatever the initial surplus; or a bank can go bankrupt whatever its initial ratio of core capital. The orders of magnitude suggest to search for ways to circumvent the sustainability issue in case of a catastrophic event through reducing both the risk and the cost of the catastrophic event itself. ABSTRACT We provide a first attempt to include off-balance sheet, implicit insurance to SIFIs into a consistent assessment of fiscal sustainability, for 27 countries of the European Union. We first calculate tax gaps à la Blanchard (1990) and Blanchard et al. (1990). We then introduce two alternative measures of implicit off-balance sheet liabilities related to the risk of a systemic bank crisis. The first one relies of microeconomic data at the bank level. The second one relies on econometric estimations of the probability and the cost of a systemic banking crisis, based on historical data. The former approach tends to maximize the fiscal cost of systemic banking crises, whereas the latter one tends to minimize it. Hence we believe that the combined use of these two methodologies helps to gauge the range of fiscal risk. JEL Classification: Keywords: H21, H23, J41 Fiscal sustainability, systemic banking risk, off-balance sheet liabilities. 4

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